Commentary

Jumping on the inflation train

Commentary: Dollar sell-off lets inflation genie out of bottle

By

BryanPerry

ROCKVILLE, Md. (MarketWatch) -- Less than 90 days ago, the financial markets were melting down, with the world's economies mired in a deflationary death spiral that threatened to usher in another 1930's-like extended downturn.

To combat the demons of deflation, the U.S. government -- through the many newly created stimulus packages -- is on track to issue as much as $12 trillion in combined future debt to boost the ailing domestic economy.

The net effect of all this freshly minted money could be rampant inflation, where the dollar loses substantial value against other currencies and yields on Treasury bonds spike higher.

During the past two weeks, that premise is taking a firm hold in the bond trading pits and rates are gapping higher with every Treasury auction. The inflation genie is now out of the proverbial bottle and it's still early in the debt-issuance phase of this worrisome scenario.

The current deterioration in the value of the U.S. dollar was not a matter of if, but when. Now the recent blow-off in the greenback to six-month lows has fund managers all over the world closing out long bond positions and rotating into floating rate bonds at a dizzying pace.

As a result, income investors need to be diversifying out of long-term, fixed-income bonds and diversifying heavily into instruments that benefit from rising interest rates. They also should get on the side of inflation rather than trying to fight it, or worse, trying to ignore it.

The yield on the benchmark 10-year Treasury note has jumped from 2.5% to 3.7% since mid-March, anticipating the Fed will have to raise rates to support the dollar in the wake of monster-sized Treasury auctions to pay for the many stimulus programs now in place.

Rumors abound about how credit agencies will lower the AAA rating of U.S. government-backed debt because of the bloated budget deficit, as well as China's rhetoric about moving away from the dollar as the world's reserve currency.

These two concerns along with some hints of the economy stabilizing later this year have stoked the fires of eventual inflationary pressures, setting off a buying binge in inflation-indexed securities.

The theme surrounding 2009 is all about "change." So at the end of 2008, I looked over what we own on our buy list and decided to make some strategic changes to enhance total returns, given the current investment backdrop. The market is constantly changing with new leadership emerging in every sector, so it is important for us to be open to moving money where it is best served for our purposes.

To the rescue are Treasury Inflation-Protected Securities or TIPS as they are fondly known. Back in early January, I advised purchasing the iShares Lehman TIPS Bond
TIP, +0.04%
the most actively traded exchange-traded fund that offers investors a managed approach to tackling looming inflation.

This fund is designed to track Lehman Brothers U.S. Treasury Inflation Notes Index, which measures the performance of the inflation-protected public obligations of U.S. Treasury TIPS Index on a leveraged basis. And since I believe interest rates can't go any lower, but in fact will increase in the coming months due to monetary inflation, this should compel foreign buyers to load up on floating-rate U.S. Treasury bonds.

So if we can capture a 5%-10% yield in an inflation-sensitive ETF that pays monthly, we're well ahead of the eventual inflation curve and in position to well handle the double threat of inflation, or heaven forbid, stagflation where growth is slow and inflation soars higher.

So the strategy here is fairly simple. We are anticipating that as the Treasury issues trillions of dollars in newly created debt, the dollar will come under fierce selling pressure, forcing interest rates higher to attract buyers of that debt, such as China.

In addition, as the economy comes back to life later this year, the Fed will have to raise key benchmark interest rates accordingly, making instruments that adjust higher with interest rates and inflation a strong asset class to own.

I expect shares of the iShares Lehman TIPS Bond to trade back up to the $110 level by year's end, providing income investors with a total return of 10%-20% depending on how high Treasury yields trade and how much the monthly dividend is increased as a direct result of being pegged to higher rates.

It's pretty vanilla for this to work -- the Fed Funds Rate has to rise in the current year from zero percent to whatever. I like my chances.

Buy the iShares Lehman TIPS Bond under $102 and put the Pepto Bismol back in the pantry.

Bryan Perry is editor of "Bryan Perry's Cash Machine." His web site is www.cashmachineincome.com

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